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How Stock Market Insurance Can Protect You from This Decline

Editor’s note: With the market selling off you might be interested in a simple way to protect yourself from further declines. I recently put together a video on 3 income strategies that can benefit from a falling market. Click here to watch this free video presentation now.

Most everything you've heard about investing from the mainstream media, your mutual fund advisor and your tax accountant is a lie.

Hear me out.

You’ve been told by the financial industry that the entire point of portfolio diversification is to mitigate downside risk, right? Yet when the market experiences the inevitable decline, every sector pushes significantly lower - and your “diversified” portfolio suffers as a result.

The idea of portfolio diversification began with an article by Harry Markowitz in 1952. And since then, diversification has been the cornerstone of Modern Portfolio Theory and portfolio risk management.

In fact, the entire "retail" sector of investing - including all mutual funds, all 401(k) managers, index investing, etc. - all grows literally out of that original diversification idea from Markowitz.

We have been taught to spread our investments across a healthy range of stocks in different industries to reduce our downside risk exposure. It’s as basic as supply and demand.

The logic behind this approach to risk management (a form of investment portfolio "insurance") goes something like this: If the retail sector falters, another industry such as consumer staples may be immune to whatever plagued the retail sector. For example, if retail stocks plunge because a recession hits, broke consumers are not going to stop buying toothpaste and laundry detergent - so consumer staples stocks are less likely to suffer.

But as you can plainly see from the chart below, when a bear market occurs - like the ones in 2002 and 2008 - it doesn't matter what sector you choose. It doesn’t really matter what sectors you choose. All sectors fail during significant downturns … and fail miserably.

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When Harry Markowitz came up with the Modern Portfolio Theory in 1952, he wasn't privy to the ultimate way to truly protect your portfolio. That’s because the best way to insure against downside risk did not exist in 1952. So while Harry did his best given the tools available at the time, his recommendations for diversification simply can't provide real insurance today.

It was roughly 21 years AFTER Harry Markowitz introduced his theory that real stock market insurance was brought to market. And even though it's been another 40 years since that advent, most investors STILL don't know about the single best and easiest method of portfolio insurance.

If you haven't guessed yet, I'm talking about options.

You probably don't realize that options were originally created to act as a form of insurance. That's because options are just contracts to cover your stock holdings under very specific circumstances.

While options were created to help investors mitigate risk, most investors use options for speculation. That’s why options tend to get a bad rap as risky investments.

But it doesn’t have to be that way. Going back to our example with retail and consumer staples, you can protect both sectors with options.

Let me explain.

Let’s say you own 100 shares of the Retail Holders Trust (RTH) at $46. Recently, the overall market and RTH pushed into an intermediate-term overbought state such that you believe the market will witness a decline over the next few months. What’s more, you suspect this decline could exceed 10% and will likely affect the retail sector similarly.

There are several ways to use options if you are bearish. You can use vertical spreads if you’re moderately bearish or sell out-of-the-money calls if you are mildly bearish. But we think a sizeable correction is around the corner, and we want to protect a good portion of our returns from the recent rally.

In order to protect (hedge) your investment, you can buy one June put contract at the 42 strike on RTH. This option gives you the right to sell your 100 shares for $42, no matter how low the share price drops before the option expires in June (June 21).

Since the put option at the 42 strike is out of the money (the strike price is below the current share price), you can buy a June 42 RTH put for $0.65, or $65 per contract. You are now hedged - or insured - against losses below $42 for a cost of only $65 on a portfolio that has a value of roughly $4,600.

Easy, right?

The extra $65 spent on the RTH put is the cost of protection, or insurance. Thus the cost to insure your $4,600 investment is $65, or only 1.4%.

But this is more than just an insurance policy, which is typically just cash out the door.

If RTH goes up to say $56, you will have a profit of $935 ($1,000 increase in the shares less the $65 for the put insurance). Of course your profit would be the full $1,000 had you decided not to hedge your investment.

However, if RTH falls to say $36, or roughly by 22%, your loss will be limited to $400 because your put gives you the right to sell your shares for $42. Had you decided not to protect your portfolio, your loss would be $1,000. The small $65 cost of protection doesn't look so bad now, does it?

Of course, you could limit your loss to only 5%, or even nothing, if you wish. Just pick a strike price that’s closer to the current RTH price. That’s a wonderful aspect of options - you can create your own risk profile.

I hope that you picked up a few tips on how to protect your portfolio. You might be a trader or a buy–and-hold investor. Either way we all want to protect our capital. And using options is one of the most effective ways.

As always these are just guidelines, and personal preferences can obviously vary. Just remember, it’s all about finding the best insurance policy for your own situation.

Again, if you want to learn more about the options strategies I use, please join my Options Advantage service. For just $39 you receive 2 months of Options Advantage. You can cancel at any time during your 2-month trial and receive a full refund. No questions asked.